In his recent Mises Daily article The Social Function of Credit-Default Swaps, Philipp Bagus argues that markets for credit default swaps (CDSs) on government debt, including naked credit default swaps, essentially provide a limit on government debt by spreading a distrust in government ability to pay. As a consequence, attempts at restricting their scope might be considered ill-advised by those interested in limiting government activities.
Bagus’s clear reasoning is certainly right, as far as it goes, but it is our contention that a decisive element is lacking in the picture he paints, an element that makes for a far more nuanced picture to say the least, once it is taken into account. To put it simply, Bagus might be right in the short term, but there are permanent forces at work which actually make CDS markets very useful for governmental purposes.
Bagus’s argument, as specifically applied to sovereign CDS markets, is the following: Since CDSs exist in the first place to compensate investors for a loss if a debtor defaults on its obligation, the fee that the buyer of the CDS pays represents some sort of an insurance premium. And this price reflects the degree of confidence or lack thereof that people involved in these trades have in the underlying government bonds, say Greek bonds, for example.
Now, as it appears to some actors that Greek debt is becoming more risky, an additional demand for the related CDS arises and rising fees reflect this distrust. A self-reinforcing spiral is set into motion. The signal of distrust makes other people more distrustful than they would otherwise be and less eager to buy government bonds, which then increases interest rates and payments on bonds and creates in turn an additional demand for CDSs . . . and so on until the government cannot find further funding.
The role played by CDSs in this story is therefore unambiguous. By spreading distrust initially caused by government debts and spending excesses, CDSs’ premiums actually point out the unsustainability of government policies, increasing distrust in the government and therefore making people less eager to cooperate with the body politic by lending funds to it. As a result, the crisis comes sooner than it would have otherwise, saving the public from additional governmental distortions in society’s structure of production.
The first problem here is that even if one can readily concede that the spiraling scenario is conceivable and even probable in the current mess, it does not necessarily have to happen. It depends on a set of crucial assumptions regarding how price “signals” are interpreted and how actors shape their expectations as a consequence. From the point of view of pure economics, given expectations do not always follow from the same conditions of action. Otherwise, we would not talk about actors. So the explanation is valid insofar as the implicit psychological theory underlying the scenario applies to the studied case. Therefore, Bagus’s conclusions can be valid provided they are not considered as a general explanation or the outcome of pure economic reasoning.
If it does not follow from Bagus’s story that CDSs necessarily restrict a government’s ability to borrow and spend, could one still identify some systematic or permanent impact of CDS markets’ existence? It should be clear that the answer is positive and straightforward. In general, when Mr. A specializes in uncertainty bearing and allows someone else, Mr. B, to get rid of that risk to some extent, B will be able and more eager to expose himself to the “risk” on the margin. More specifically, if someone can protect himself against the default of a debtor, he will be more eager to lend than otherwise. Therefore, if one can buy sovereign CDSs, one will be more eager to buy government bonds. In other words, the very existence of CDS markets implies a permanently higher demand for bonds than if they were absent, which in turn implies higher bonds prices and lower interest rates.
This means that as far as government funding is concerned, CDS markets are generally helpful, even if the speculation on it can sometimes backfire by revealing government weaknesses. The point is that in facilitating government funding, limits on government debt are actually looser than they would otherwise be. And the more unregulated CDS markets are, the “better”. When naked CDSs are allowed, for example, CDS markets are more liquid. Easiness in trading CDSs means cheaper “insurance” and less risk in buying the underlying bonds. The “structural” impact is then favorable to government even though, in some circumstances, the effect described by Bagus can superimpose itself on the more general tendency and possibly win out.
As Robert Pickel, executive vice chairman of the International Swaps and Derivatives Association, recently stated, “absent a liquid sovereign CDS market, hedgers of risks attributable to a government bond or other assets related to the country would instead move to short or sell any bonds or other country-related assets”. It is true that political decision makers have a short-run interest in blocking trade in these products, not only out of pure demagoguery, but also for the sake of breaking the spiral effect described by Bagus. But they also have this opposite long-run interest to make these markets as liquid as possible, an interest obvious to professionals in the field and, therefore, presumably familiar to many political decision makers.
Unless politicians freak out, we should therefore not expect outright bans on CDSs, but rather temporary or very partial bans. We should also expect some deregulation via the authorization of more and more sovereign CDS trading on public exchanges (where products are by default prohibited until approved by the regulators), politicians selling deregulation to the public as a move towards more regulation.
As Less Antman has shown in a Freeman article, “unregulated CDSs markets” actually mean that CDS trading has been confined to over-the-counter transactions by de facto prohibition of CDSs on public trading exchanges (under the Commodity Futures Information Act in the US). They have been “unregulated” in the sense that public trading regulation could not apply to them since they were not authorized on public exchanges. However, it should be clear that regulated public trading—however strict—amounts to less regulation than no public trading allowed at all. Partial prohibition is not all out prohibition.
One can actually already observe such moves toward “more regulation” (in plain language, “less regulation”, i.e. the possibility of trading CDS on public exchanges) in the US and in Europe, which, in a statist framework, is not good news for people interested in limiting government activities, insofar as it implies pushing back the limits of government debt and spending. Libertarians would therefore have to expose the scheme and fight back. After all, if buying government bonds is not recommendable, buying sovereign CDSs should not be either.